Bank of England calls the bottom
Is the financial sector now so dependent on central banks that it needs to be told when assets are cheap? That is one possible conclusion from the Bank of England’s latest Financial Stability Report. The key piece of analysis is a comparison of the global aggregate market prices of subprime securities, with an estimate of their fundamental value. Tricky though this calculation is, it cuts to the heart of whether the world’s banking system is through the worst.
The Bank, using mainstream, pessimistic, assumptions on defaults and loss rates, thinks that subprime securities with an aggregate par value of about $900bn now have a fundamental worth of about 81 per cent of face value. Market prices, as implied by credit derivative indices, are far more pessimistic, suggesting, in aggregate, subprime securities are worth 58 per cent of face value. The writedowns taken by financial institutions (banks, insurers and investors mainly) have overshot slightly too, implying subprime securities are worth 80 per cent of face value.
If the analysis is right, banks’ balance sheets could actually see small write-backs, while there may be a $210bn profit opportunity for anyone brave enough to pile into subprime. Is the analysis right? The Bank has a good analytical track record on subprime losses, having produced one of the first accurate assesments in October. The real question is whether the judgement that credit derivative subprime prices have overreacted justifies the Bank’s wider assesement that the worst is over.
There are two reasons to be hesitant. The first is that sub-prime securities (at par value) are equivalent to only 3 per cent of European and US bank assets. On the basis of their performance in subprime, the risk that these institutions have behaved foolishly on other products appears quite high, particularly as economic conditions slow. Secondly, despite far more transparency on subprime exposures, major bank capital raisings, and generous central bank policies, interbank lending rates remain oddly high. It is hard to feel comfortable about banks when they do not trust each other.